Model answers for practice paper 3A suitable for Edexcel A Economics

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Contents

1(a) Explain the difference between primary income and secondary income in the current account. Refer to Figure 1 in your answer. (5 marks)

Net primary income includes cross-border flows of interest, profit and wages. These are payments for provision of factors of production such as labour. Net secondary income includes cross-border flows of aid and remittances and involve redistributing income. Net primary income has remained at 0.2% of GDP for the euro area in 2023 and 2024, suggesting more inflows than outflows of primary income. Net secondary income as a percentage of GDP has marginally increased from -1.2% to -1.1% for the euro area from 2023 to 2024.

1(b) Referring to Extract A, paragraph 1, examine two causes of unemployment in mainland Europe. (8 marks)

One cause is real wage inflexibility. This means real wages cannot fall to bring the labour market into equilibrium. This could be because of wages being stuck above the free market equilibrium wage, due to wage agreements between trade unions and employers lasting “as long as five or six years.” This may reduce demand for labour (contraction). As a result there is excess supply of labour, in other words the unemployment rate rises.

Another cause is not having the skills for the jobs available, known as occupational immobility, a type of structural unemployment. Some workers in “Bulgaria lack the digital skills required in today’s job market”. This could lower demand for labour, as workers are less productive without these digital skills. This could reduce employment and increase unemployment.

However, government funded training schemes for digital skills could give workers new skills that are in demand in the job market. This increases worker productivity, boosting labour demand and could reduce structural unemployment.

1(c) Using a diagram, discuss the effect of joining a common market, such as the European Union, on social welfare. Refer to Extract A in your answer. (12 marks)

Joining a common market such as the EU could reduce trade barriers, leading to trade creation. For example, 63.6% of imports into France come from other EU member states. Having tariff-free access to these imports, such as “cars from Germany such as Volkswagen”, shifts the world supply down from Sw+tariff to Sw for the French car market. This reduces the price for consumers from pw+T to pw, leading to an increase in imports from (q3-q2) to (q4-q1). There is an increase in consumer surplus of area A+B+C+D. Consumers are better off from more competition leading to lower prices. The additional price competition results in an overall welfare gain from tariff reduction by areas B+D, as the rise in consumer surplus outweighs the fall in producer surplus (area A) and government revenue (area C). For area D, this is because consumers are consuming more units of the good, increasing consumer surplus. For area B, these units are produced by a more efficient foreign producer once tariffs are removed, reducing costs in a way that is passed on to the consumer with lower prices.

However, joining the EU means putting in place the Common Customs Tariff (CCT). This includes a 42.2% average tariff rate on dairy imported from outside the EU. This extra tariff could increase costs of importing, leading to higher prices and lower consumer surplus.

Also, France is a net contributor to the EU budget. This could increase France’s budget deficit, leading to higher government borrowing and debt interest payments rising. This could reduce the funds available to spend on healthcare domestically, reducing health and social welfare.

1(d) Evaluate the microeconomic and macroeconomic advantages for a country of joining a monetary union. (25 marks)

One microeconomic advantage is higher profits. Joining the monetary union means lower costs of currency conversion for businesses. Businesses do not have to pay transaction fees to a middle man to convert currencies between the lev and the euro. For example, the Pirdop copper refinery does not have to pay currency conversion fees when importing raw copper and exporting refined copper between the rest of the euro area and Bulgaria (some of Bulgaria’s main imports and exports). As a result, the firm’s costs fall. Specifically, average cost shifts down from AC to AC1 and marginal cost shifts down from MC to MC1. This reduces the price from p1 to p2 and increases supernormal profit (SNP) from (p1-c1)q1 to (p2- c2)q2. This makes firms more dynamically efficient, as firms can use the SNP to invest back into the business. For example, in making the copper refinery process more efficient, which may bring down costs over time and further increase profit.

However, currency conversion fees between the lev and the euro may only be a small proportion of total costs for Bulgarian businesses. This is because the Pirdop facility may export to and import from other countries outside the euro, where joining the monetary union does not reduce currency conversion costs. 55% of Bulgaria’s exports go to non-euro countries. These costs may only be a small percentage of firm costs in any case, with raw materials and labour being larger costs. As a result, the fall in MC/AC may be smaller, resulting only in a smaller increase in profits for companies.

A macroeconomic advantage is increasing the economic growth rate and the employment rate. Monetary union makes it easier for consumers to compare prices in different countries, with more prices being denominated in euros. This increases competition between firms in different countries, forcing firms to cut costs by being more productive. 83% of Bulgarian imports come from the euro area, so the monetary union could lead to more price transparency and competition between imports and domestic products. This shifts LRAS right to LRAS1 due to competition increasing productivity, and cost-cutting shifts SRAS right to SRAS1. Altogether this leads to an increase in real GDP from Y1 to Y2, increasing the economic growth rate and a fall in price level from PL1 to PL2. The fall in price level leads to an extension in aggregate demand (AD), as lower domestic prices boost export competitiveness for goods such as wheat and oil, increasing export demand which is a component of AD. As there is an extension in AD, there is an increase in derived demand for labour needed to produce the extra goods, reducing the unemployment rate.

However, joining a monetary union could slow the economic growth rate. To join the euro area, countries have to meet conditions such as a maximum fiscal deficit of 3% of GDP. This could require a reduction in government spending. G is a component of AD, so AD could shift left. This could also reduce government spending on supply-side policies such as education spending, reducing the human capital of the country and shifting LRAS left. This could reduce equilibrium real GDP, slowing the rate of economic growth.

Overall, the macroeconomic effect of higher economic growth is likely to be larger in the long term. Easier price comparison is likely to generate extra competition and boost LRAS, given the large fraction of Bulgarian imports coming from euro area countries (83%). However in the short run, economic downturns could be deeper due to the inability to increase government spending and the lack of independent monetary policy, being controlled by one central bank the ECB. The microeconomic effect of lower costs leading to higher profits is likely to be small, with currency conversion costs likely only a small proportion of total costs.

1(e) Evaluate the microeconomic and macroeconomic consequences of quantitative tightening. (25 marks)

A macroeconomic effect is a fall in the rate of inflation. Indeed part of the reason for quantitative tightening (QT) is “to help bring down inflation from its peak in 2022”. QT involves the central bank selling (mainly) government bonds to financial
institutions, with the ECB reducing asset holdings by 15 billion euros a month. This reduces the amount of cash that financial institutions, such as commercial banks, have available to lend. So commercial banks lend less funds. So it is more difficult for firms to borrow money to invest, reducing investment. Investment is a component of aggregate demand (AD = C + I + G + X – M). So a fall in investment shifts AD left from AD1 to AD2. At the same time this could cause a negative multiplier effect. The fall in investment means firms selling capital goods have less revenue and profit. So they cannot pay their workers as much, so wages fall, so consumption falls, shifting AD further left from AD2 to AD3. As a result of the two AD shifts to the left, real GDP falls from Y1 to Y3 and the price level falls from PL1 to PL3. This helps bring down the rate of inflation closer to target, helping to achieve this macroeconomic objective.

However, this depends on the level of spare capacity. The economy may have unused factors of production as reflected in the euro-area unemployment figure of 6.4% in April 2025. If there is a high level of spare capacity, this could make the LRAS perfectly price-elastic at low levels of output. This means it is easier for firms to change production levels in response to price changes. This could put the economy on the horizontal part ofthe Keynesian LRAS. In this case, a shift left in AD does not reduce the price level, failing to bring down the rate of inflation.

A microeconomic effect is reduced firm profits. Quantitative tightening leads to an increase in the supply of government bonds from the ECB selling government bonds. As a result, the price of the government bonds falls and the yield rises(investors now have to pay less, due to the lower price, to receive the same coupon payments). This attracts investors to invest more in government bonds, reducing investment in stocks and corporate bonds. Reduced demand for (corporate) bonds may lead to lower bond prices and higher corporate bond yields. This makes it more expensive for companies to borrow to invest, increasing interest costs for companies, which could be seen as a fixed cost. Companies may face “tighter credit conditions”. As a result, a firm’s average cost curve shifts upwards from AC to AC1, making it “more difficult for firms to fund capital expenditure” such as machines for the Bulgarian copper refinery. This lowers supernormal profit from (p1-c1)q to (p1-c2)q, leading to lower profits and a supernormal loss. If AR < AC due to the rise in cost, this could make firm shutdown more likely in the long run.

However, commercial banks may have high confidence if they believe firms are likely to continue to grow in the euro area. Indeed high inflation in 2022, if caused by demand-pull factors, could be a sign of high economic growth and growing business revenues. So the banks may continue to invest in companies even if government bond yields appear more attractive. So companies may continue to have access to loans without higher interest costs, so profits may not fall. So QT may not lead to firm shutdown.

Overall, the macroeconomic effect of lower inflation is likely to be larger than the microeconomic effect of lower firm profits. Given that unemployment rates in some countries in the euro area are low by historical standards, the economy is likely near full capacity. So low spare capacity suggests that quantitative tightening is likely to reduce inflation. Whether profits fall depends on the industry. Some industries that require upfront capital investment such as the machinery and factories for refining copper in Bulgaria may suffer from higher borrowing costs. However, other firms that invest using retained profit may not see higher costs.

2(a) Referring to Extract C, paragraph 1, explain one impact of a divorce of ownership from control. (5 marks)

The divorce of ownership from control means that the managers/CEOs managing the day-to-day operations in the firm are different people to those who own the firm, shareholders. Shareholders may want to maximise profit, while managers may want to maximise sales to improve their own reputation. This results in sales maximisation (producing where AR=AC) which may reduce profits and dividends for shareholders, with 40% of shareholders voting against plans for the CEO’s pay to rise at Centrica. “An expected fall in profits in the first quarter of 2025” for Centrica may mean that shareholders think the CEO is not maximising profits.

2(b) Examine two possible reasons why a maximum wage for CEOs could lead to government failure. Refer to Extract C in your answer. (8 marks)

One possible reason is relocation of companies, as “CEOs and businesses may decide to set up abroad to avoid this pay cap”. Companies, operated by CEOs, may move their location abroad to avoid the maximum wage. This may have the unintended consequence of fewer firms in the UK, which may reduce the demand for non-CEO workers in the UK, leading to higher unemployment.

However, coordinating maximum wages with other economies may reduce the incentive for CEOs to move abroad.

Another possible reason is by distorting wage signals by lowering CEO wages to meet the “maximum 10:1 pay ratio” between bosses and lowest paid workers, there may be a contraction in CEO labour supply due to the reduced incentive to work. At the same time, demand for CEOs may extend if they become cheaper. This results in excess demand for CEOs and underemployment of CEOs in the UK.

However, companies may be incentivised to raise wages of lower-paid employees, instead of cutting CEO pay to meet the pay ratio cap.

2(c) Using a supply and demand diagram, assess the impact of higher input costs for sandwich shops on consumer surplus and producer surplus. Refer to Extract D in your answer. (12 marks)

An increase in food and energy costs for sandwich shops could increase a firm’s costs of production. An example is the price of white bread increasing from £0.58 to £0.84 per 800g. This reduces the incentive to supply sandwiches, shifting supply of sandwiches left from S to S1. As a result the equilibrium price rises from p1 to p2 and the equilibrium quantity falls from q1 to q2. Consumers are worse off because sandwiches have become more expensive, so consumers cannot afford to buy as many sandwiches. Consumer surplus falls from p1AB to p2FB, a fall of area p1AFp2.

However, part of the increase in food costs could be because of firms switching to buying higher quality ingredients. This could improve the taste (quality) of sandwiches, so demand may not fall, so consumer utility may not fall.

Producers are worse off from the higher input costs, as “higher energy and food costs are squeezing margins”. The supply shift left results in producer surplus falling from p1AC to p2FE. This is because higher input costs eat into the profit margins, making producers of sandwiches worse off. Firms can only pass on some of the cost to consumers with higher prices, so that demand does not fall as much, so costs increase by more than revenues.

However, demand may be price-inelastic if people visit the same sandwich shop out of habit. So the firm could pass on most of the extra costs to consumers by raising prices. This reduces the extent to which producer surplus and profits fall.

2(d) Evaluate the microeconomic and macroeconomic factors leading to pay gaps between CEOs and other workers. (25 marks)

A microeconomic factor is differences in skills. CEOs may have received extra management training or education or have learnt management skills from experience. This increases their productivity, leading to higher demand for their labour compared to other workers. So labour demand for CEOs is at DL1, compared to DL for other workers. At the same time, the education and experience required to be a CEO may only leave a “small pool of qualified leaders” available for the CEO role. As a result, labour supply shifts left and becomes more wage-inelastic for CEOs, rotating from SL to SL1. This results in a higher equilibrium wage for CEOs at w2 compared to the wage for other workers at w1. The higher wage for CEOs occurs because at w1, the wage mechanism steps in to eliminate the excess demand for CEO at the wage for other workers. Wages increase to incentivise more CEOs to supply labour and to ration demand until CEO labour supply meets demand. This could explain why CEOs in the UK are paid £4.58 million a year on average in 2024/25, compared to only £39,039 for the median worker in the UK.

However, there might not be a large difference in skills between CEOs and other workers. Instead CEOs may find jobs through “connections, rather than skills”. This would mean there may not be some extra training that makes CEOs more productive than other workers, but workers are rewarded for who they know rather than their productivity. This could occur because company boards may lack information about the productivity of employees and so rely on connections to refer potential CEOs, or because of a non-meritocratic company culture. So labour demand may not be higher for CEOs due to extra training, so training differences may not explain the wage gap

A macroeconomic factor behind higher CEO pay relative to other workers is globalisation. Globalisation may also mean that multinational companies offshore parts of their production process to countries with lower labour costs. This reduces costs for the company, increasing profits further. This gives more funds to pay dividends to shareholders. So the CEO can receive a higher income through higher dividends, particularly where their pay is dependent on the performance of the company, such as 84% of CEOs receiving Long Term Incentive Payments, often in the form of company shares. Globalisation could also increase the complexity of the firm’s operations, with multiple factories in different countries, “the ability of a good CEO maymatter more than ever in managing increasingly complex organisations”. This could increase the demand for senior managers like CEOs to organise and coordinate the different parts of the firm. A shift right in labour demand for CEOs boosts equilibrium wages. Meanwhile, globalisation may lead to firms reducing demand for junior employees due to the offshoring, replacing workers in the UK with cheaper workers in factories abroad. So demand for junior employees shifts left,leading to lower equilibrium wages for this group, creating a wage gap between CEOs and other workers.

However, globalisation is also associated with an increase in labour mobility between different countries. Globalisation may make it easier for a UK firm to source CEOs from other countries, because of greater migration flows and
more remote working. UK university graduates worked 1.8 days a week from home on average, which could make it easier to find CEOs further from the company office. This could make CEO labour supply in the UK increase and become more wage-elastic, owing to the larger pool of more qualified candidates. This could cancel out the effect of higher labour demand for CEOs, meaning that globalisation may not necessarily lead to higher wages for CEOs.

Overall, the microeconomic cause of differences in training or education is likely more significant than the macroeconomic cause of globalisation in leading to a wage gap between CEOs and other workers. Globalisation increases labour demand but also labour supply for CEOs, which could result in a neutral effect on CEO wages. Meanwhile, differences in education or training are likely to drive CEO wages up relative to other workers. Government retraining schemes are unlikely to close the gap, as CEOs may have decades of training through their studies and experience. However, this does depend on the firm, as some firms may hire based on connections rather than on a worker’s abilities.

2(e) Evaluate the microeconomic and macroeconomic consequences of more workers working from home. (25 marks)

A microeconomic effect is lower profit for sandwich shops. “Sandwich shops in London may not have the trade they once had”, suggesting falling demand for sandwich shops in city centres. This could be because workers spend less time in city centres and more time in their home area or at home. This shifts the sandwich shop’s MR and AR lines downwards to MR1 and AR1. This reduces the price of sandwiches from p1 to p2, and the output from q1 to q2. As a result, the supernormal profit falls from area (p1-c1)q1 to (p2-c2)q2. This makes the sandwich shop less able to benefit from dynamic efficiency. This means it has less supernormal profit to invest in making the sandwich production line more efficient, so costs of producing sandwiches may not fall over time. Sandwich shops may also have reduced funds to invest in improving the quality of their food over time, such as better quality ingredients.

However, the redistribution of consumption around the country means sandwich shops in rural locations or locations outside major cities may benefit. With workers spending more in their local area, they are more likely to come across and use local sandwich shops. This increases demand for local sandwich shops, so AR/MR rises, so profits rise, so local sandwich shops become more dynamically efficient.

A macroeconomic effect of more people working from home could be higher economic growth. University graduates in the UK worked 1.8 days a week from home on average. Working from home may reduce the geographical immobility of labour, as workers no longer need to be within commuting distance of a job to work at a company, working remotely instead. Working from home also enables more workers to enter the labour force who have other responsibilities to manage, such as “some carers, parents and people with certain disabilities” that otherwise make it difficult to be at work full-time. This all increases the supply of labour available to firms, a factor of production. So LRAS shifts right to LRAS1, increasing productive capacity. This leads to a fall in the price level from PL1 to PL2 and a rise in equilibrium real GDP from Y1 to Y2, leading to economic growth. This leads to an extension in the aggregate demand curve from Y1 to Y2, as the falling price level gives workers more purchasing power, increasing consumption for a given wage.

However, working from home could reduce innovation. With extra barriers to communication from screens and distance compared to sitting next to other employees, this could make it harder for some staff to learn on the job and to “innovate and communicate”. This could slow the growth rate of human capital and the rate of technological progress, reducing productivity compared to a world without working from home. This could shift LRAS left and slow the UK’s long-run rate of economic growth.

Overall, the macroeconomic effect of working from home, higher economic growth, is likely to be large. While there are conflicting effects on worker productivity (less distraction at home versus less innovation through collaboration), the effect on labour supply is likely to be significant, bringing more workers into the labour force. Given that UK university graduates work from home more than in other European countries, the increase in labour supply could be much larger for the UK. The microeconomic effect of lower profit is less significant for chain sandwich shops with locations across the country. While some in big city centres will lose out, other sandwich shops in the chain will gain more customers and higher profits, balancing out the effect on profits of chains.

Final thoughts

These answers were written by me. They are likely to score full marks or close to this.

I have also written the practice paper for these questions. Practice papers are best used for extra practice ahead of the exam.

Hope you find these questions and answers helpful!

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